I read an article in the Financial Times earlier this week (September 23, 2023) -…
It is Wednesday so very little blog writing today. One question I often get asked is what would happen if the bond market investors in a nation stopped bidding for the debt instruments being offered in the regular auctions. Interestingly, overnight I was sent some news from a Deutsche Bank information service written by their New York-based Chief International Economist, who signs himself off as “Torsten Sløk, Ph.D”. It related to these issues. The problem is that Dr Sløk seemed to want to take a snide shot at Modern Monetary Theory (MMT) and just made a fool of himself. It goes on. This is what the point is.
Dr Sløk has a Ph.D. Okay. That doesn’t mean much if it has come from a mainstream economics graduate program.
Every day, PhDs from that sort of program make statements that should disqualify them from any further participation in the debate.
The title of Dr Sløk’s snippet was “Bid-to-cover trending down” and the accompany message had this text:
The bid-to-cover ratio at auctions for 2s and 10s have been trending lower in recent years see also here. You wonder how this fits into the MMT theory.
Followed by this graph:
Some education to follow.
1. “MMT theory” is redundant. The T in MMT makes it so.
2. What is a bid-to-cover ratio and is it important?
I explain bid/cover ratios in this blog post – D for debt bomb; D for drivel (July 13, 2009).
The bid-to-cover ratio is just the the $ volume of the bids received to the total $ volumes desired. So if the government wanted to place $20 million of debt and there were bids of $40 million in the markets then the bid-to-cover ratio would be 2.
First, the use of the ratio assumes it matters. It doesn’t matter at all where the government issues its own currency and is thus not revenue-constrained.
Second, such governments choose the way in which the debt instruments are issued. The organisation of debt issuance is not dictated by the ‘market’ but a matter of government prerogative.
For example, in Australia, the Federal government changed the way government bond markets operated in the 1980s.
The changes to the ‘operations’ of the bond markets was a voluntary choice by the Government at the time based on a growing acceptance of neoliberal ideology.
They were also the result of special pleading by the private bond dealers who wanted to refine their dose of corporate welfare (the ability to purchase risk-free assets).
There was nothing essential about the changes. Further, they were largely cosmetic.
The Government replaced the former ‘tap system’ of bond sales with an ‘auction model’ to eliminate the alleged possibility of a ‘funding shortfall’.
Previously, governments (such as in Australia) ran what were called ‘tap systems’ of bond issuance.
Accordingly, the government would determine the maturity of the bond (how long the bond would exist for), the coupon rate (the interest return on the bond) and the volume (how many bonds) that was being sought.
If the private bond traders determined that the coupon rate being offered was not attractive relative to other investment opportunities, then they would not purchase the bonds.
The central bank, typically, would then step in and buy up the unwanted issue.
This system, which was very effective and allowed the government to completely control the yield (it set the coupon) was anathema to the neo-liberals, who considered it gave the central bank carte blanche to fund fiscal deficits.
Tap systems were replaced by competitive auction (tender) systems, where the the issue is put out for tender and the private bond market determine the final yield of the bonds issued according to demand.
Bonds are issued by government in the so-called ‘primary market’, which is simply the institutional machinery via which the government sells debt to the authorised non-government bond dealers (some banks etc).
In a modern monetary system with flexible exchange rates it is clear the government does not have to finance its spending so the the institutional machinery is voluntary and reflects the prevailing neo-liberal ideology – which emphasises a fear of fiscal excesses rather than any intrinsic need for funds (of which the currency-issuing government has an infinite capacity).
Once bonds are issued in the ‘primary market’ they are traded in the ‘secondary market’ between interested parties (investors) on the basis of demand and supply.
The bid-to-cover ratio refers to the demand in the primary market by the private dealers for the government debt on offer.
Clearly secondary market trading has no impact on the volume of financial assets in the system – it just shuffles the wealth between wealth-holders.
In the primary market, when demand is high, the yield will be lower, whereas, if demand is low, the auction will push the yield up on the issue.
Imagine a $1000 bond had a coupon of 5 per cent, meaning that you would get $50 dollar per annum until the bond matured at which time you would get $1000 back.
Imagine that the market wanted a yield of 6 per cent to accommodate risk expectations (inflation or something else). So for them the bond is unattractive and they would avoid it under the tap system.
But under the tender or auction system they would put in a purchase bid lower than the $1000 to ensure they get the 6 per cent return they sought.
The mathematical formulae to compute the desired (lower) price is quite tricky and you can look it up in a finance book.
The general rule for fixed-income bonds is that when the prices rise, the yield falls and vice versa. Thus, the price of a bond can change in the market place according to interest rate fluctuations.
When interest rates rise, the price of previously issued bonds fall because they are less attractive in comparison to the newly issued bonds, which are offering a higher coupon rates (reflecting current interest rates).
When interest rates fall, the price of older bonds increase, becoming more attractive as newly issued bonds offer a lower coupon rate than the older higher coupon rated bonds.
Further, rising yields may indicate a rising sense of risk (mostly from future inflation although sovereign credit ratings will influence this).
But they may also indicate a recovering economy where people are more confidence investing in commercial paper (for higher returns) and so they demand less of the risk free government paper.
So you see how an event (yield rises) that signifies growing confidence in the real economy is reinterpreted (and trumpeted) by the conservatives to signal something bad (crowding out, increased cost of government spending).
The yield reflects the last bid in the bond auction. So if diversification is occurring reflecting confidence and the demand for public debt weakens and yields rise this has nothing at all to do with a declining pool of funds being soaked up by the bingeing government!
Under auction systems, the process certainly ensures that that all net government spending is matched $-for-$ by borrowing from the primary bond market dealers.
So net spending appears to be ‘fully funded’ (in the erroneous neo-liberal terminology) by the market.
But in fact, all that was happening was that the Government is coincidentally draining the same amount from reserves as it is adding to the banks each day and swapping cash in reserves for government paper.
The bond drain means that competition in the interbank market to get rid of the excess reserves will also not drive the short-term interest rate down.
The auction model merely supplies the required volume of government paper at whatever price is bid in the market.
So there is never any shortfall of bids because obviously the auction would drive the price (returns) up so that the desired holdings of bonds by the private sector increased accordingly.
Third, it is highly interpretative as to what the bid-to-cover ratio signals.
It certainly signals strength of demand but how strong becomes an emotional/ideological/political matter.
Even if you believed that the government was financing its net spending by borrowing, then a bid-to-cover ratio of one would be fine – enough lenders to cover the issue.
Some commentators think that 2 is a magic line below which disaster is imminent. There is no basis at all for that.
There is also no basis in the statement that a ratio above 3 is successful and by implication a ratio below 3 is unsuccessful.
After all, anything above 1 tells you that some investors do not get their desired portfolio. That sounds like a failure to me.
A declining bid-to-cover ratio might signal that investors are diversifying their portfolios in a growing economy where private asset risk is declining for a time.
That is the most likely reason the ratios have been falling in the US Treasury auctions since arond 2012.
Fourth, for sovereign governments the bid-to-cover ratio is somewhat irrelevant because such a government could just abandon the auction system whenever it wanted to if the ratio fell to say, 0.00001.
If the Bid-to-Cover ratios at bond auctions fell to zero – that is, private bond dealers offered no bids for an auction – then the government could simply instruct the central bank to buy the issue.
They might have to change some regulations to allow that but just as nations shifted away from ‘tap systems’ to ‘auction systems’, they can shift back again easily (in most cases).
Fifth, what about the world losing ‘confidence in the dollars we owe’ (we being the US government)?
Presumably this would manifest in the bid-to-cover ratio falling such that the authorised bond dealers no longer wanted to purchase the bonds.
What then? Not much.
So for obvious reasons, none of this has much bearing on whether MMT is a credible monetary framework for understanding how modern fiat currency systems work.
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The new site is being built from scratch and is currently incomplete but we are working on making the material more accessible.
Music I have been listening to while working today
I was going late 1970s today – in particular, I dug out an excellent album from West Indian born – Joan Armatrading – who is both a great singer and a great guitar player.
This song – Willow – was on her 1977 album – Show Some Emotion (A&M), which was semi-popular at the time.
But I liked it nonetheless.
The album has some great Hammond organ on it (John Bundrick).
That is enough for today!
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